the rights of creditors of affiliated...

The Rights of Creditors of Affiliated CorporationsRichard A. Posnert

In a recent article in the Review, Jonathan Landers attemptsan ambitious rethinking of legal policy toward the creditors of affili-ated corporations.' He organizes his discussion around three specificquestions:

(1) The parent company has advanced funds to its sub-sidiary in the form of a loan; if the subsidiary does not haveenough assets to satisfy all of its creditors, should the parentbe treated differently from other creditors?

(2) If a subsidiary is unable to satisfy a creditor's claimout of its own assets, should the creditor be entitled to satisfyhis claim out of the assets of the corporate parent (i.e., to"pierce the corporate veil")?

(3) If two affiliated corporations become bankrupt,should the assets of, and the claims against, the two corpora-tions be pooled?

Landers believes that a group of affiliated corporations is a singleeconomic enterprise in reality and should be treated as such by thelaw. This belief leads him to answer all of the above questions af-firmatively, with two major qualifications.

First, Landers does not think that existing law-reflecting as itdoes a settled if perhaps questionable legislative policy in favor oflimited shareholder liability-is sufficiently flexible to accommo-date a general rule of piercing the corporate veil. The furthest thatjudicial reform can go in this area, in his opinion, is to allow the veilto be pierced whenever the parent of the bankrupt corporation has

t Professor of Law, University of Chicago; Senior Research Staff, National Bureauof Economic Research. The economic analysis of the credit process in this paper is drawn inpart from F. Black, M. Miller & R. Posner, An Approach to the Regulation of Bank HoldingCompanies (January 1974, unpublished). I am grateful to James E. Beardsley, Fischer Black,Walter J. Blum, Richard A. Epstein, Bernard D. Meltzer, Phil C. Neal, George J. Priest,Kenneth E. Scott, George J. Stigler, and the participants in the Law and Economics Work-shop of The University of Chicago Law School for helpful comments on a previous draft ofthis paper, and to Brian J. McCollam for his valuable research assistance.

Landers, A Unified Approach to Parent, Subsidiary, and Affiliate Questions inBankruptcy, 42 U. CHi. L. REv. 589 (1975). Landers limits his analysis and recommendationsto the case where the parent corporation owns 100 percent of the stock of each subsidiary sothat there are no minority shareholders. Id. at 590 n.4.

The University of Chicago Law Review

failed either (1) to endow the subsidiary with sufficient resources tomake it economically viable or (2) to observe the formalities pre-scribed by state law for creating a separate corporation. 2 Second,Landers recognizes that consolidation of bankrupt affiliates may beunfair to a creditor who has relied on the separate character of theaffiliate to which he extended credit; forcing him to compete withthe creditors of another corporation for access to the debtor's assetswould undermine his reliance. Landers therefore proposes to protecta creditor's specific reliance where proved.3 Subject to these qualifi-cations, Landers would greatly reduce the respect accorded corpo-rate forms when they are invoked by a corporation to defeat theclaims of creditors of an affiliate.

Landers's analysis appears to be shaped by a conception of thecredit process as one in which scheming entrepreneurs manipulatehapless creditors. The entrepreneur creates multiple corporations inorder to avoid the legitimate claims of creditors and others, such asthe Internal Revenue Service; he juggles the assets of the enterpriseamong the corporations to thwart these claimants; and all this oc-curs against the background of a law of corporations that, in Lan-ders's view, fails to accord adequate protection to creditors evenwhen they are dealing with a nonaffiliated corporation. "Throughlow capitalization requirements and the uncertain prospect of veilpiercing, the law has, to a large extent, placed the cost of promotingnew businesses on the creditors of the corporation and, throughthem, on the public as a whole." 4 Corporation law, Landers believes,has externalized the risks of business failure from the shareholdersto the creditors; his proposed reforms would shift some of these risksback to the shareholders, where they belong.

Landers writes persuasively and his legal scholarship is meticu-lous. But his neglect of economic principles vital to an understand-ing of credit transactions, limited liability, and corporate affiliationundermines both his general approach and his specific conclusions.I shall attempt to elucidate these economic principles in the firstpart of the paper and apply them to the three specific questionsexamined in Landers's article in the second. Part I is also designedto stand by itself as a general introduction to the economic analysisof problems in corporation law and related fields.

2 Id. at 621.3 Id. at 632.1 Id. at 593.

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Affiliated Corporations

I. THE SIMPLE ECONOMICS OF CORPORATE FINANCE

A. Credit Transactions and Limited Liability

Mr. A. Smith wants to borrow $1 million to invest in a miningventure together with $2 million of his own money. He wants theloan for only a year since by the end of the year it will be apparentwhether the venture has succeeded; if it has, he would then wantto obtain longer-term financing. Since Smith is a man of means, ifhe gives his personal note to the lender the latter would regard aone-year loan of $1 million as riskless and would offer Smith theriskless short-term interest rate, say six percent. But Smith is reluc-tant to stake more than $2 million on the outcome of the miningventure. He proposes to the lender a different arrangement, wherebythe lender will agree to look for repayment of the loan exclusivelyto the assets of the mining venture, if any exist, a year hence. Underthis arrangement, Smith will be able to limit his liability to hisinvestment in the venture.

The lender estimates that there is an 80 percent probabilitythat the venture will be sufficiently successful to enable repaymentof the loan and interest on the due date, and a 20 percent probabilitythat the venture will fail so badly that there will be insufficientassets to repay even a part of the loan. On these assumptions' thesolution to the lender's problem is purely mechanical; he must cal-culate the amount, payable at the end of a year, that when mnlti-plied by 80 percent (the probability that payment will in fact bemade) will equal $1,060,000, the repayment he would have receivedat the end of the year had he made the riskless loan. That amountis $1,325,000. 7 Accordingly, the lender will charge Smith 32.5 per-cent interest for the loan if Smith's obligation to repay is limited tothe assets of the venture. At this rate of interest the lender is indif-ferent as between the riskless and the risky loan.

This example illustrates the fundamental point that the inter-est rate on a loan is payment not only for renting capital but alsofor the risk that the borrower will fail to return it. It may be won-dered why the borrower might want to shift a part of the risk ofbusiness failure to the lender, given that he must compensate himfor bearing added risk. There are two reasons why the lender mightbe the superior risk bearer. First, the lender may be in a better

5 To simplify exposition, I ignore the intermediate possibilities.

I Plus the additional assumption that the lender is "risk neutral." This term is explained

in note 8 infra.7 Calculated by solving .8x = $106 for x.

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position than the borrower to appraise the risk. Compare the posi-tions of the individual shareholder in a publicly held corporationand the banks that lend the corporation its working capital. It maybe easier and hence cheaper for the bank to appraise the risk of adefault and the resulting liability than it would be for the share-holder, who may know little or nothing about the business in whichhe has invested. Second, the borrower may be risk averse and thelender less so (or risk neutral, or even risk preferring).8 Thus, unlim-ited liability would discourage investment in business ventures byindividuals who wanted to make small, passive investments in suchventures. It would also discourage even substantial entrepreneurialinvestments by risk-averse individuals-and most individuals arerisk averse.'

A borrower could in principle negotiate with the lender for anexpress limited-liability provision. The more usual course, however,is to incorporate and have the corporation borrow the money. Thebasic principle of corporation law is that the shareholders of a corpo-ration are not personally liable for the corporation's debts unlessthey agree to assume such liability. Corporate borrowing thereforeautomatically limits the borrower's liability to his investment in thecorporation. The fact that the law permits Smith to limit his liabil-

I An.individual is risk averse if he prefers the certain equivalent of an expected value tothe expectation-the certainty of receiving $1 to a 10 percent chance of receiving $10. A riskpreferrer would have the opposite preference, and a risk-neutral individual would be indiffer-ent. A corporation is less likely to be risk averse than an individual because the shareholdersof the corporation can offset any risks incurred by that corporation by holding a diversifiedportfolio of securities. Moreover, a large lender can eliminate or greatly reduce the risk of losson a particular loan by holding a diversified portfolio of loans. On both counts it seems likelythat individual investors would often be more averse to bearing unlimited personal liabilityfor the failure of an enterprise in which they had invested than lenders would be to bearingthe risk of that failure to the extent of their loan to the enterprise.

Risk aversion is implied by the principle of the diminishing marginal utility of (money)income. The principle of diminishing marginal utility is easiest to grasp in the case of atangible commodity like hats: the more hats one has, the less each additional hat contributesto one's utility. Although money is a much more versatile good than hats, the principle ofdiminishing marginal utility should hold: as people obtain more dollars, the increment totheir utility contributed by each additional dollar should become progressively smaller. Sup-pose that an individual derives 50 utiles (an arbitrary nonmonetary measure of welfare) fromthe last dollar that he possesses, but would derive only 40 utiles from having another dollar.Then he would not pay a dollar for a 50 percent chance of obtaining two dollars (even thoughthe dollar cost and expected dollar gain of the wager are the same-$1), for the disutility tohim of the transaction-50 utiles-would exceed the expected utility-45 utiles (50 percentof 90 utiles, the payoff if the wager is successful). Since some people do gamble, it is plainthat not all people are consistently risk averse. But there is considerable empirical evidencethat most investors, at least, are risk averse, as the theory of diminishing marginal utilitywould imply. The evidence is summarized in J. LORIE & M. HAMILTON, THE STOCK MARKET:

THEORIES AND EVIDENCE 198-227 (1973).

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ity by conducting his mining venture in the corporate form does notimply, however, that the law is somehow tilted against creditors orenables venturers to externalize the risks of business failure, as Lan-ders argues.10 Although incorporation permits Smith to shift a partof the risk of failure to the lender, there is no externality; the lenderis fully compensated by the higher interest rate that the corporationmust pay by virtue of enjoying limited liability. Moreover, thelender is free to insist as a condition of making the loan that Smithguarantee the debts of the corporation personally or that he consentto including in the loan agreement other provisions that will limitthe lender's risk-though any reduction in the risk will reduce theinterest rate the lender can charge since a portion of that rate is, aswe have seen, compensation to the lender for agreeing to bear a partof the risk of the venture.

There is an instructive parallel here to a fundamental principleof bankruptcy law: the discharge of the bankrupt from his debts.This principle, which was originally developed for the protection ofbusiness rather than individual bankrupts,"I enables the venturer tolimit his risk of loss to his current assets; he is not forced to hazardhis entire earning capacity on the venture. Incorporation performsthe same function of encouraging investment by enabling the riskaverse to limit their risk of loss to their investment.

Far from externalizing the risks of business ventures, the princi-ple of limited liability in corporation law facilitates a form of trans-action advantageous to both investors and creditors; in its absencethe supply of investment and the demand for credit might be muchsmaller than they are. Landers overlooks this essential point be-cause he is unsure of the basis for limited liability.1 2

In discussing the reciprocal relationship of risk and interestrates, I have concentrated on the risk of default that is anticipatedwhen the loan is first made. During the period that the loan isoutstanding, however, the risk of default may change. To the extentthat the change can be foreseen, it will be reflected in the interestrate negotiated at the outset. To the extent that it cannot be fore-seen, the lender may seek to protect himself by offering an amor-tized loan (which is repaid continuously rather than in a singlepayment at the end of the term), even if the assets available to repaythe loan are not expected to depreciate physically. Since the balanceoutstanding on the loan declines as a function of time and hence of

,O Landers, supra note 1, at 619-20.

" See 2 W. BLACKSTONE, COMMENTARIES *473-74.12 See Landers, supra note 1, at 617-19.

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the probability of unforeseen changes in the risk of default, thelender is protected in part against those changes. Nor is the bor-rower prejudiced. Should no unforeseen increases in risk material-ize, the borrower will be able to negotiate a reduction in the interestrate as the outstanding balance of the loan declines.' 3 If the lenderrefuses to renegotiate the interest rate, the borrower can replace theloan at a lower rate from another lender; if there is a penalty in theloan agreement for prepayment, the borrower was presumably com-pensated for agreeing to it and cannot complain.

The parties will find it difficult, however, to adjust the interest.rate or other terms of the loan to reflect the possibility of the bor-rower's deliberately increasing the lender's risk. After the interestrate has been agreed upon and the loan agreement signed, the bor-rower may increase the risk of defaulting on the loan by, for exam-ple, obtaining additional loans not subordinated to the first or trans-ferring assets to its shareholders or others without adequate consid-eration. 11 In effect the borrower has unilaterally reduced the interestrate he is paying for the loan. That rate was negotiated with refer-ence to a lower anticipated level of risk than has come to pass. Giventhe actual level of risk, the borrower is being allowed to borrowmoney at less than its true cost.

To protect himself against such dangers the lender may insistthat the borrower agree to limit his total indebtedness or theamount of dividends payable during the term of the loan, where"dividend" is broadly defined to include any disposition of corpo-rate assets for less than full market value. Or the lender may insiston some minimum capitalization, impose other restrictions, or re-quire collateral. Alternatively he may decide to forgo protection anddemand a higher interest rate. It may be difficult, however, to quan-

"1 This will be true unless he has in the meantime assumed other liabilities as a resultof which the risk of defaulting on the loan may be unchanged or even increased. See text andnote at note 14 infra.

11 Anything that increases the borrower's debt-equity ratio will increase the likelihoodof default, because debt charges are fixed costs to the firm and cannot be reduced if thereare adverse business developments, such as a decline in demand for the firm's product, thatlead to a reduction in its earnings.

It might be asked why a firm would deliberately increase the risk of its defaulting on theloan, since any short-rn gains will usually be outweighed by the long-run loss of creditorconfidence, resulting in much higher interest rates when the firm next wants to borrow. Thisis true for the firm that expects to remain in business for the indefinite future. But the firmthat expects to be bankrupt and is trying to minimize the impact of bankruptcy on itsshareholders will discount, perhaps to zero, the loss of creditor confidence, and firms of thissort presumably account for a substantial fraction of the actual defaults. The danger that afirm which has in fact defaulted will, prior to default, have taken various measures thatincreased the risk of default to some of its creditors is thus a substantial one.

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tify the probability that the borrower will deliberately attempt toincrease the riskiness of the loan.

Although the analysis to this point has focused on the explicitloan, it also applies to extensions of credit in other forms. For exam-ple, the merchant who does not insist on payment in cash and theemployee who is not paid until the end of the week are creditors,and their estimation of the risk of default will determine the amountof credit extended, the length of time for which it is extended, andthe interest rate (which, of course, need not be stated separatelyfrom the sale price or wage rate). The major difference between thetrade creditor and the financial creditor is that the latter, becausehe is a specialist in credit and because the amount of credit that heextends to each creditor is apt to be larger, is much more likely tonegotiate the terms of credit explicitly. This means, as we are aboutto see, that the provisions of corporation law will have a greaterimpact on credit transactions with trade creditors than on thosewith financial creditors.

B. The Economic Effects of Corporation Law

An important implication of the foregoing analysis is that thespecific doctrines of corporation law should not be expected, in gen-eral, to have a profound impact on the credit system or to alter thebalance of advantage between debtor and creditor. 15 If corporationlaw did not provide for limited shareholder liability, then in situa-tions where the parties desired to limit that liability in exchange fora higher interest rate the loan agreement would contain an expressprovision limiting liability. Conversely, under existing law a firmasked to lend money to a corporation in which it lacks confidencecan insist as a condition of making the loan that the shareholdersagree to guarantee repayment personally; of course, the interest ratewill be lower than it would have been without such a guarantee.

Similarly, if the rules of corporation law limiting the paymentof dividends to the amount of "earned surplus" shown on the corpo-ration's books effectively protect creditors against attempts by firmsto increase the risk of default after the loan has been made, well andgood. But if corporation laws were amended to drop all limitationson the payment of dividends, the major consequence would be thatthose creditors who wanted dividend limitations would have to askthat they be written into the loan agreement.

,5 Cf. Coase, The Problem of Social Cost, 3 J. LAW & ECON. 1 (1960).

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There are, however, exceptions to the proposition that corpora-tion law does not affect the allocation of resources. One is the invol-untary extension of credit. A pedestrian is struck by a moving vanin circumstances making the moving company liable to him for atort. Pre-existing negotiations, explicit or implicit, between the par-ties with respect to the moving company's ability to make good onthe pedestrian's claim are simply not feasible. Since the partieshave no opportunity to transact around the provisions of corporationlaw, the provisions governing limited liability may alter the relativeposition of debtor and creditor.

A more common exception occurs where, although the contextis one of voluntary transacting, the costs of explicitly negotiating thequestion of extent of liability are high in relation to the stakes in-volved. The slight probability that an employee will be seriouslyinjured on the job, when multiplied by the probability that theemployer will have insufficient assets to satisfy his claim for work-men's compensation, may be too small to warrant inclusion of anexpress term in the employment contract to cover that contingency.In this case, too, whatever term is implied as a matter of corporateor bankruptcy law will control the parties' relations even if it iscontrary to what the parties would have negotiated in a world of zerotransaction costs. But there is an important difference: the wagerate can adjust to compensate the worker for the risk of nonpaymentof any *compensation claim that he may some day have against hisemployer. Such compensation for bearing an added risk of nonpay-ment is precluded in the case where the parties have no contractualor potentially contractual relationship at all-the usual situation inan accident between strangers.

These exceptions to one side, the primary utility of corporationlaw lies in providing a set of standard, implied contract terms, forexample, governing credit, so that business firms do not have tostipulate these terms anew every time they transact, although theycould do so if necessary. To the extent that the terms implied bycorporation law accurately reflect the normal desires of transactingparties, they reduce the cost of transactions. The criterion of anefficient corporation law is therefore whether the terms do in factreflect commercial realities, so that transacting parties are generallycontent with them. A corporation law that is out of step with thoserealities, and so induces contracting parties to draft waivers of thecontract terms supplied by the law, is inefficient because it imposesunnecessary transaction costs.

Thus a corporation law is inefficient if it fails to provide stan-dard implied contract terms that afford creditors the sorts of protec-

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tions against default that they would normally insist upon in anexpress negotiation. Such a law can be criticized for creating avoid-able costs of explicit negotiation. In some cases it can also be criti-cized for leading creditors to forgo desired protective provisions andto settle instead for a higher interest rate as a second-best alterna-tive to the desired protection.

Landers's criticisms, however, are of an entirely different na-ture. His complaint against a corporation or bankruptcy law thatfails to give creditors adequate protection against default is that itshifts the costs of entrepreneurship from shareholders to creditors.Except in the special case of the tort creditor, 6 this is a seriousoverstatement. At the worst, such a law may lead to somewhathigher interest rates as compensation for the absence of protectiveprovisions that would reduce the risk of default; more probably itwill lead simply to lengthier credit agreements. Transacting partieswill negotiate explicitly the inclusion of protective provisions thata proper corporation law would read automatically into the credittransaction. The additional transaction costs, to the extent thatthey are borne in the first instance by the lender, will be passed onin whole or part to the borrower in the form of a (slightly) higherinterest rate," thereby reducing the amount of credit extended, pre-sumably also slightly. But this will be the only allocative effect of acorporation law that fails to give the creditors the protections theywould normally demand. And observe that such a law hurts borrow-ers as well as lenders, by raising interest rates."

C. Creditor Protection: The Problems of Information andSupervision

Let us take a closer look at the types of protection that creditorswould normally insist upon and that would therefore be found in anefficient corporation or bankruptcy statute. It is convenient to div-ide the sources of risk faced by the creditor into two types along thelines of the earlier analysis. The first is the risk of default based oncircumstances known or anticipated when the loan is made. The

" And even this case must be qualified. Where the tort occurs between the parties to apre-existing contractual relationship (e.g., a bus passenger injured by the bus driver's negli-gence), the costs of the accident are not externalized.

" Thus the interest rate may be viewed as having three components: the cost of risklesscapital (which includes any anticipated inflation), the cost of the risk assumed by the lender,and the administrative costs of the credit transaction incurred by the lender.

18 The analysis of the economic effects of corporation law is, of course, merely a specialcase of the economic analysis of contract law, i.e., the law governing voluntary transactions.See R. POSNER, ECONOMIC ANALYSIS OF LAW 41-65 (1973).

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creditor's interest is not necessarily in minimizing this risk; since itis compensated risk any measures taken to reduce it will also reducethe interest rate. The creditor's interest lies rather in forming anaccurate idea of the risk, for otherwise he cannot determine whatinterest rate to charge. Assessment of the risk of default requiresaccurate information about the existing and expected assets andliabilities of the borrowing corporation and of anyone else who maybe liable for the corporation's debts, insofar as those assets andliabilities effect the creditor's ability to obtain repayment. Copingwith this risk presents the problem of information. Measures thatincrease the creditor's costs of information are prima facie undesir-able. A good example of such a measure would be misrepresentationby the borrower of his solvency.

The second source of risk to the creditor is the possibility thatthe corporation will take steps to increase the riskiness of the loanafter the terms have been set. The problem of coping with this riskis the problem of supervision; the creditor must supervise or regu-late the corporation's disposition of its assets to the extent necessaryto prevent any deliberate attempts to reduce the assets available torepay the loan. Dividend limitations are an illustration of the super-vision type of credit term.

Obtaining information and supervising a corporation's internalaffairs are costly undertakings. Economizing on these costs is oneobjective, social as well as private, of the provisions in a creditinstrument. The first question to ask about any existing or proposedcreditor's right under corporation or other laws is whether it actuallyreduces the creditor's information or supervision costs. It is often adifficult question to answer, because of differences in the costs ofinformation and supervision to financial, trade, and nonbusiness 9

creditors, because of the debtor's ability to increase those costs byvarious acts and omissions, and because of differences in the natureof the collateral put up by different debtors (e.g., land versus inven-tory).

The analysis, moreover, cannot stop with a consideration of thecreditor's costs. The goal is to minimize not just the administrativecosts of the credit transaction but its total social costs. Even if a ruleabrogating the limited liability of corporate shareholders wouldlower the costs of credit administration by reducing the risk of de-faulting on a loan and thereby decreasing the optimal level of ex-penditures on supervision and information,2 it would probably be

See pp. 522-23 infra.20 It is not certain that it would reduce those costs overall, however, since creditors of

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an uneconomical rule because it would prevent a type of risk shift-ing (from shareholders to creditors) that is apparently highly effi-cient, judging by its prevalence. To the extent that-paradoxical asit may seem-risk can often be borne more cheaply by creditorsthan by shareholders, a rule that prevented the shifting of risk fromthe latter to the former would impose costs in undesired risk thatmight be much greater than the savings in reduced costs of creditadministration. Similarly, a rule that forbade any payment of divi-dends to corporate shareholders would reduce supervision costs byincreasing the assets available for the payment of creditors' claims,but it would also reduce the attractiveness of owning stock to thoseinvestors who do not consider appreciation a perfect substitute forperiodic income.2' It would probably not be an optimal rule consid-ering all the relevant costs and benefits of corporate activity.

The ultimate objective of the credit process is to minimize theoverall social costs of capital through a complex allocation of costs,including the disutility of risk, between borrower and lender. Mea-sures that minimize the risk borne by the creditor will lower interestrates both directly and by reducing the creditor's optimum expendi-ture on obtaining information and supervising the debtor's busi-ness.22 But beyond a certain point the cost to the investors of theadded risk they are made to bear may well exceed the reduction ininterest rates. It is of no benefit to a corporation to be able to borrowat six percent on condition that its shareholders personally guaran-tee repayment of the loan, if the expected earnings of the corpora-tion are insufficient to compensate the shareholders for giving sucha guarantee. An efficient corporation law is not one that maximizescreditor protection on the one hand or corporate freedom on theother, but one that mediates between these goals in a fashion thatminimizes the costs of raising money for investment.

D. The Reasons for and Consequences of Corporate Affiliation

Landers is interested in the special case of the creditor of acorporation wholly owned by, or otherwise 100 percent affiliated

individuals exposed to unlimited liability for the debts of corporations in which they hadinvested might, in consequence, have to make a more extensive investigation of such individ-uals' creditworthiness.

21 The transaction costs involved in selling stock in order to convert appreciation intocash income may make periodic income preferable to appreciation for some investors.

Capital requirements imposed by the lender on the borrower are to be understood inthis light: the more heavily capitalized the borrower is, the less likely he is to dissipate assetsnecessary to repay the loan by withdrawing capital from the enterprise in the form of divi-dends or otherwise.

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with, another corporation. To understand this case it is necessaryto consider how it might come about that one corporation wasowned by or in common with another corporation. Landers's im-plicit explanation is that an entrepreneur will decide, typically inorder to avoid taxes or limit other liabilities, to divide a unitaryenterprise-a single business in economic terms-into a series offormally separate but commonly owned and controlled corpora-tions. Under this view of how corporate affiliation arises, the sepa-rate corporate status of the different parts of the enterprise is indeedfictional (whether it is harmful is a separate question). But the viewis seriously incomplete.

To begin with, often a group of affiliated corporations is not asingle enterprise at all. Even before the vogue of the "conglomer-ate," there were many highly diversified enterprises, comprising anumber of distinct businesses, often separately incorporated andrelated only in the integration of a few headquarters functions suchas legal counseling and securities issuance. How might the commonownership of seemingly unrelated businesses come about? There area number of possibilities. First, there may be managerial or finan-cial economies (the businesses aren't really unrelated). Second, theowners may be trying to reduce risk through diversification. Third,an enterprise may decide to expand internally (through a separatecorporation) into an unrelated line of business because it perceivesopportunities for greater profits than its shareholders could earn ifthe funds employed in entering the new line were instead distrib-uted to the shareholders as dividends. 23 A related point is that a firmwhich is not well managed is an attractive target for a takeover bid,normally by another corporation rather than by an individual or agroup of individuals. The bidder may not be in the same or even ina related line of business. It may instead be a specialist in identify-ing undervalued firms. But the takeover bid is only the most dra-matic illustration of the operation of the market for corporate assets.The existence of such a market implies that corporations are fre-quently in the market for other corporations, sometimes in differentlines of business.

Where a commonly controlled pool of capital is employed in anumber of different lines of business, it is not at all obvious that theowners of the pool should be treated differently from other ventur-ers. It is especially doubtful in the case of "lateral piercing," which

1 Transaction costs would be lower if the corporation invested directly and there wouldalso be tax savings to the shareholders.

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Landers appears to regard as indistinguishable in principle frompiercing the subsidiary's corporate veil to reach the parent's assets.24

Suppose that individuals who in the aggregate own 100 percent ofX Corporation's stock create a new corporation, Y, to engage in anunrelated business. X and Y are affiliates, and Landers I take itwould like the creditors of Y to be able to reach the assets of X. Butwhy should a group of investors be treated differently by the law justbecause they own a corporation engaged in an unrelated business?And if they should not be treated differently, then why, if X, actingas an agent of its shareholders, forms Y in order to engage in anunrelated business, should X's liabilities (and therefore those of itsshareholders) be greater than those borne by other entrants into Ysmarket?

Landers's implicit answer is that X may take steps to increasethe risks borne by creditors of Y. X may, for example, cast its equityinvestment in Y in the form of a loan, thus reducing the assetsavailable to satisfy claims of Y's genuine creditors, without disclo-sure to those creditors. But the same danger is present in the caseof two corporations owned by the same individuals. Indeed, it ispresent in the case of an unaffiliated corporation. There is a conflictof interest between the personal shareholder and the creditor as wellas between the corporate shareholder and the creditor; in both casesmanagement has an incentive to try to shift uncompensated risk tothe creditor. Is the danger greater when the shareholder is a corpora-tion? Probably it is greatest in the closely held corporation whetherthe dominant shareholder is an individual or a corporation. Argua-bly, therefore, if a shareholder that is a corporation should not bepermitted to hide behind limited liability when the subsidiary cor-poration is unable to pay a creditor's claims, neither should theshareholder who is an individual be permitted to invoke limitedliability when the corporation in which he owns stock is unable tosatisfy the corporation's debts. The logic of Landers's argumentswould seem to require the abolition of limited liability across theboard.

To this it may be objected that there is a greater social interestin according limited liability to personal shareholders than to corpo-rations, in order to make investment in enterprises attractive toindividuals who would be deterred from investing by the prospectof potentially unlimited personal liability for the debts of the enter-prise. A partial answer to this objection is that when a corporation

24 See Landers, supra note 1, at 590, 606, 628.

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undertakes a new venture, it simply cuts short the process by whichcorporate assets are first distributed to shareholders in the form ofdividends and then reinvested by those shareholders in a new corpo-ration that undertakes the venture. The corporation's liabilitiesshould therefore be no greater than those of its shareholders, whomight have made the investment directly (though at a higher cost),without subjecting their interest in the old corporation to liabilityon account of the new corporation's debts. But this argument over-looks a difference between individual and corporate investment. Ifa parent corporation is made liable for its subsidiary's debts, theexposure of the parent's shareholders to liability, although greaterthan if the subsidiary enjoyed limited liability, is still limited totheir investment in the parent. Making a parent liable for the sub-sidiary's debts will not result in unlimited personal liability for theparent's shareholders, whereas making a personal shareholder liablefor corporate debts would have this effect.

However, the implication of this point-which is that unlimitedcorporate-shareholder liability would have a less dampening effecton individual investment than unlimited personal-shareholder lia-bility-is applicable primarily to the large publicly held corpora-tion, where, as we shall see, the objections to limited liability in theaffiliation context are weak. The investor in the large corporationis ordinarily in a position to minimize the risk that is transmittedto him through the ventures undertaken and liabilities incurred bya corporation in which he owns stock simply by holding a diversifiedportfolio of corporate securities. Unlimited corporate-shareholderliability would threaten such an investor far less than unlimitedpersonal-shareholder liability. But the investor in a small corpora-tion frequently does not enjoy the same opportunities for diversifica-tion. He cannot protect himself against the consequences of unlim-ited liability of corporate shareholders as effectively as the investorin the large corporation.

To understand this important point, suppose in our example ofthe Smith mining venture that the Smith fortune (other than thatwhich Mr. Smith plans to commit to the mining venture) is investedin a radio station owned by a corporation of which Smith is the solestockholder. If he forms a new corporation to conduct the miningventure, and if "lateral piercing" is permitted as Landers wouldlike, then Smith has hazarded his entire fortune on the outcome ofthe mining venture. This may be an unacceptable risk to him. Inthis case there is in fact no difference between piercing the corporateveil to reach the assets of an affiliated corporation and piercing it

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to reach an individual shareholder's assets. The case is extreme, butapproximations to it are not uncommon in the world of small busi-ness. This example is to me a decisive objection to a general rule ofpiercing the corporate veil to reach the assets of an affiliated corpo-ration. And the case is no different if, instead of Smith's forming anew corporation to conduct the mining venture, he invests $2 mil-lion more in the radio station which then forms a subsidiary toconduct the venture.

Landers's only reason why the case for limited liability isweaker for corporate than for personal shareholders is that affiliatedcorporations, even if engaged in totally unrelated lines of business,will be managed differently from independent firms because theowners will seek to maximize the profits of the enterprise as a wholerather than the profits of any individual corporation.2 5 This argu-ment is unconvincing. Normally the profits of the group will bemaximized by maximizing the profits of each constituent corpora-tion. Indeed, if the corporations are engaged in truly unrelated linesof business, the profits of each will be completely independent.

It is true that the common owner can take measures that con-ceal or distort the relative profitability of his different enterprises,as by allocating capital among them at arbitrary interest rates. Butit is not true, as Landers implies, that owners invariably or typicallyadopt such measures. For one thing, such measures are costly be-cause they reduce the information available to the common ownerabout the efficiency with which his various corporations are beingmanaged. The costs rise rapidly with the size of the overall enter-prise. That is why large corporations typically treat their majordivisions and subsidiaries as "profit centers," which are expected toconduct themselves as if they were independent firms.26 For similarreasons, divisional managers are compensated on the basis of theprofitability of the subsidiary or division rather than of the enter-prise as a whole.27

Even when the activities of affiliated corporations are closelyrelated-when they produce substitute or complementarygoods-normally each corporation will be operated as a separateprofit center in order to assure that the profits of the group will bemaximized. It is only in the exceptional case that maximizing the

" See, e.g., id. at 624-25.

2, In some cases, however, the profit center may not coincide with divisional or corporate

boundary lines.27 See, e.g., United States v. International Tel. & Tel. Corp., 306 F. Supp. 766, 782-83

(D. Conn. 1969); 0. WILLIAMSON, CORPORATE CONTROL AND BUSINESS BEHAVIOR 109-81 (1970).

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profits of a group of related corporations will involve different be-havior from what could be expected of separately owned corpora-tions.18 To be sure, where there are genuine cost savings from com-mon ownership, as in some cases where the affiliated corporationsoperate at successive stages in the production of a good, the twocorporations will be managed differently from separately owned cor-porations in the, same line of business in the sense that their opera-tions will be integrated in a way independent corporations' are not.But that would not mean that either corporation was, in any senserelevant to the reasonable expectations of creditors, something otherthan a bona fide profit-maximizing firm. Rather, each corporationwould simply be more profitable than its nonintegrated competitorsbecause its costs were lower. It would be perverse to penalize sucha corporation for its superior efficiency by withdrawing the privilegeof limited liability enjoyed by its nonintegrated competitors. More-over, in this case as well, the common owner has a strong incentiveto avoid intercorporate transfers that, by distorting the profitabilityof each corporation, make it more difficult for the common ownerto evaluate their performance. That is why the price at which onedivision of a vertically integrated firm will "sell" its output to an-other division is normally the market price for the good in question(less any savings in cost attributable to making an intrafirm transfercompared to a market transaction), rather than an arbitrary trans-fer price designed artificially to enhance the profits of one divisionat the expense of the other.

The important difference between a group of affiliates engagedin related businesses and one engaged in a number of unrelatedbusinesses is not that the conduct of corporations in the first groupwill differ from that of nonaffiliated corporations in the same busi-nesses, but that the creditor dealing with a group of affiliates inrelated businesses is more likely to be misled into thinking that heis dealing with a single corporation.29 The mere possibility of decep-tion in some affiliation cases does not in logic justify disregarding

21 For example, if one affiliate had a monopoly of business machines, and the other soldthe punch cards used in the machines, the common owners might decide to lease the ma-chines at cost and charge a high price for each card as a method of price discrimination thatwould generate higher profits for the enterprise as a whole than if each corporation maximizedits profits separately. However, as this example suggests, most of the cases in which thecommon owners will not seek to maximize the profits of each corporation separately are casesin which one or more of the corporations has monopoly power; and many such attempts toexercise monopoly power, as in the "tie-in" example given above, would violate the antitrustlaws. See generally Posner, Exclusionary Practices and the Antitrust Laws, 41 U. CI. L. REv.506 (1974).

" See text and notes at notes 38-43 infra.

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the corporate form in all such cases. Deception is rather one of thefactors to be considered in applying a rule of creditor protectionproperly based on the creditor's information costs. Such a rule willbe described later in this paper.

In sum, Landers's "single enterprise" approach exaggerates thedegree to which we can expect affiliated corporations to be operateddifferently from separately owned corporations. A more reasonablepresumption, especially in the case of large publicly owned firms,is that whether a corporation is owned by individuals or by anothercorporation will in general not affect the way in which the corpora-tion is managed, and so in general should not be a matter of concernto creditors. It may be true that the social interest in limited liabil-ity is somewhat attenuated in the case where the shareholder is alarge publicly held corporation. But that is scarcely a strong argu-ment for abrogating the limited liability of corporations owned bysuch shareholders, given that affiliates managed by a large publiclyheld corporation are not likely to be managed differently from howthey would be managed if they were independent firms. The dangerof abuse of the corporate form is greater in the case of the smallbusiness, where operation of the constituent corporations as sepa-rate profit centers is less necessary to assure efficient management.But an offsetting factor is that individual investors' interest in thelimited liability of corporate affiliates approaches, in the context ofsmall business, their interest in preserving the limited liability ofunaffiliated corporations.3 1

I conclude that the case for eliminating the limited liability ofaffiliated corporations has not been made. To this it may be repliedthat Landers does not want to eliminate their limited liability butsimply to require them, if they want it, to negotiate expressly for itwith their creditors. Although Landers does not discuss the possibil-ity of contracting around a general rule of unlimited liability, Iassume he would permit such contracts. However, if I am correctthat in the case of large companies creditors normally have littlereason to seek to be able to reach the assets of parent or affiliatedcorporations, and that in the case of small companies the debtorwould normally insist on expressly limiting the liability of parentand affiliated corporations, contracting around unlimited liabilitywould occur frequently and would therefore be a source of substan-tial, and avoidable, transaction costs. Moreover, as we have seen,contracting around unlimited liability for tort debts would be in-

See pp. 506-07 supra.

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feasible; and, as we shall see, methods other than corporate limitedliability for limiting tort liability are inadequate.3 1 Furthermore,while outside the tort area the costs of expressly contracting aroundunlimited liability would probably be small in the case of the finan-cial creditor (bank, etc.), with whom the debtor would have anexpress written contract anyway, those costs might be considerablewhere the debtor wished to disclaim liability to a trade or nonbusi-ness creditor-a materials supplier, employee, etc.-especially sincethe courts may refuse to enforce simple disclaimers .32 The conse-quences of eliminating the limited liability of affiliated corporationswould thus not be trivial.

II. SPECIFIC POLICY QUESTIONS

A. Landers's Proposals

1. Landers would like the creditor of a subsidiary corporationto be able always to pierce the corporate veil and reach the assetsof the parent (or an affiliated) corporation, though in deference tothe policy of limited liability he confines his specific proposal topiercing the corporate veil to cases where the subsidiary either lacks"viability" or has failed to observe the procedural formalities re-quired under the applicable state law for setting up a corporation. Ihave already suggested that a rule of indiscriminate piercing wouldoften impose unacceptable risks on the personal owners of a smallcorporation that owned or was otherwise affiliated with the corpora-tion whose veil was pierced. Risk, however, is only one factor to beconsidered. Another is the creditor's information and supervisioncosts. Landers believes those costs would be lower under a ruleallowing the subsidiary's creditors to pierce the corporate veil. Idisagree.

Take the case of unrelated businesses-the parent is engagedin the production of steel, the subsidiary in the production of corn-flakes. The costs of supervision to a creditor of the subsidiary maybe smaller if he knows that he can pierce the corporate veil andreach the parent's assets; he need not worry that the parent mightstrip the subsidiary of the assets necessary to satisfy creditors'claims. But the creditor's information costs may now be greater.Evaluating the risk that he will not be repaid will now require aninvestigation of the creditworthiness of the parent. The creditor

3, See text at note 35 infra.32 As urged by, for example, Slawson, Mass Contracts: Lawful Fraud in California, 48

S. CAL. L. REv. 1 (1974).

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unable to pierce the corporate veil would normally forgo such aninvestigation.

33

More important, a complete analysis of the effect of piercingthe corporate veil on information and supervision costs must con-sider the creditors of the subsidiary as well as those of the parent.If piercing the veil is allowed, the parent's creditors are exposed toan additional risk-that the parent's assets may be diverted to sat-isfy the claims of the subsidiary's creditors. To determine the par-ent's creditworthiness, therefore, prospective creditors of the parentmust also investigate the subsidiary's creditworthiness. Acquiringthe necessary information will become even more complicated if weallow not only the subsidiary's creditors to reach the assets of theparent, but the parent's creditors to reach the assets of the subsidi-ary, an extension implicit in the unitary-enterprise approach pro-posed by Landers.

The basic point, however, is a simpler one: there is no basis forbelieving that a general rule permitting the piercing of the corporateveil in order to reach the assets of an affiliated corporation wouldminimize the costs of credit transactions, and therefore result inlower interest rates at any given level of risk, even if it did notimpose unacceptable risks on the personal owners of affiliated cor-porations. Stated otherwise, it has not been established that a gen-eral rule allowing the piercing of the corporate veil in the case ofaffiliated corporations would approximate the normal desires of thetransacting parties.

2. Landers's proposal to subordinate a parent's loan to a sub-sidiary to the claims of the subsidiary's independent creditors is alsoobjectionable, but mainly on different grounds. Like veil piercing,the prospect of subordination would increase the risk of nonpay-ment to the parent and thereby induce the parent's creditors to takeaccount of that prospect in appraising the parent's creditworthiness.This might in turn lead those creditors to investigate the subsidi-ary's creditworthiness more carefully than if the parent were merelyanother creditor of the subsidiary. But the extent and therefore costof the additional credit inquiry would be less than in the veil-piercing case since the potential liability of the parent would belimited to the amount of the loan.

31 Even in that case, the parent's creditworthiness might affect the appropriate interestrate on a loan to the subsidiary because the parent might voluntarily mount a rescue opera-tion if the subsidiary became insolvent. Should such rescue operations be limited in order toprotect the parent's creditors? The general answer is probably "no" since failure to rescuewould often impair creditor confidence in the parent, which might increase the risk of defaultby the parent. See p. 518 infra.

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In effect, Landers is proposing that the only kind of investmentthat a corporation may make in an affiliated corporation is an, eq-uity investment. This is less objectionable than the piercing rulefrom the standpoint of burdening creditors of the parent, but it isindependently objectionable as undermining the overall efficiencyof the investment process. Parent corporations are sometimes themost efficient lenders to their affiliates because the enterprise rela-tionship may enable the parent to evaluate the risk of a default ata lower cost than an outsider would have to incur. A rule that placedheavier liabilities on a parent lender than on an outside lendermight thus distort the comparative advantages of these two sourcesof credit.

The proposed rule is a dubious one even from the excessivelynarrow standpoint of protecting creditors of the affiliate receivingthe loan. The parent may extend credit to its subsidiary on termsmore advantageous to the latter than an independent creditor wouldoffer because the parent fears that its own creditworthiness wouldsuffer if the subsidiary became insolvent. The availability of suchloans thus reduces the risk that the subsidiary will in fact default.If the parent is not allowed to make a "real" loan to a subsidiary-ifin effect the only permitted method of rescue is a contribution ofequity capital-the added risks of this method of rescue may deterthe parent from trying to salvage the subsidiary. If so, the creditorsof the subsidiary will be hurt. There is, to be sure, another side tothe coin. The parent may make the loan merely to conceal thesubsidiary's precarious state and thereby attract new creditors who,but for the loan, would have been warned away by slow payment orother symptoms of financial distress that the loan may mask. Butthis possibility indicates only that parent-subsidiary lending is sus-ceptible of abuse, and not that creditors in general would be bene-fited by a rule of automatic subordination of the parent's loan to therights of independent creditors.

3. In the case of consolidation in bankruptcy of affiliated cor-porations, Landers recognizes that the interests of two groups ofcreditors are in conflict. To the extent that one of the bankrupts hasgreater assets relative to the claims of its own creditors than theothei has, consolidation harms those creditors and helps the affili-ate's creditors. The prospect of consolidation means that a creditorcan make a total evaluation of the risks that he faces only by consid-ering the risk of insolvency of the borrower's affiliates as well as therisk of insolvency of the borrower itself. Consolidation is thus ana-lytically similar to veil piercing. Landers urges consolidation as thegeneral rule but would recognize an exception where the creditors

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of one of the corporations have specifically relied on the corporateseparateness of the borrower.

The recognition of this exception is inconsistent with Landers'streatment of the veil-piercing case. The problem of reliance on thecorporate form arises in the context of attempts to pierce the corpo-rate veil as well as in the consolidation context. Landers assumes itaway in the former context by expressly confining his discussion tocases where the parent's assets are so great that it cannot be madeinsolvent by having to answer for the debts of its subsidiaries. 4 Hereasons that in such cases the parent's creditors cannot be harmedby a change in law that would reduce the risks borne by the subsidi-ary's creditors relative to those borne by the parent's creditors. Butthis reasoning is unsound. It erroneously treats solvency and insol-vency as dichotomous states. As stressed in Part I, the interest rateon a loan is determined by the estimated risk of default and thatestimate will always fall somewhere in between zero and 100 per-cent; it will not be zero or 100 percent. Since anything that increasesthe estimated risk will lead a creditor to insist on a higher interestrate, creditors will not be indifferent to changes in law that increasethe risk of a default, even though, ex post, the default does notmaterialize. Ex ante they will incur costs to ascertain the change inthe risk of default brought about by an expansion in the rights ofcompeting creditors. To assume that the parent corporation will stillbe solvent after being made liable for the debts of a subsidiary is toassume away the principal policy issue concerning piercing theveil-its impact on the costs of credit.

B. Limited Liability and Creditors' Rights: An AlternativeApproach

Having criticized Landers's approach, I am obliged to suggesta superior alternative. Unlike Landers, I do not start from the prem-ise that the limited liability of affiliated corporations has an inher-ent tendency to externalize the costs of new business ventures, dis-advantage creditors, or increase the costs of credit transactions.Limited liability can be abused but the law should focus on theabuses and preserve the principle.

To this end, it is first necessary to make a distinction betweenthe involuntary (normally tort) creditor and the voluntary creditor.In a series of cases in New York, the courts have wrestled with the

11 Landers, supra note 1, at 606-07.

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problem of the taxi company that incorporates each taxicab sepa-rately in order to limit its tort liability to accident victims.P Interms of the analysis in this paper, the separate incorporation of thetaxicabs increases the risk that the taxi company will default on itstort obligations. If this were a negotiated obligation the creditor-victim would charge a higher interest rate to reflect the increasedrisk, but it is not, negotiations between the taxi company and theaccident victims before the accident being infeasible. The result ofseparate incorporation is therefore to externalize the costs of taxiservice. But although this result is socially inefficient, the analysiscannot stop here. Permitting the corporate veil to be pierced wouldcreate an inefficiency of another sort: investment in taxi servicewould be discouraged because investors would be unable to limittheir liability, and the information costs of creditors of affiliatedcorporations (or for that matter of creditors of noncorporate share-holders) would be increased. To be sure, the enterprise could insureitself against tort liability. But this would not be a satisfactoryalternative to limited liability. The managers might fail to take outadequate insurance; the insurance company might for a variety ofreasons refuse or be unable to pay a tort judgment against the in-sured (the insurance company might for example become insol-vent); the particular tort might be excluded from the coverage of theinsurance policy. An alternative would be to preserve limited liabil-ity but require every company engaged in dangerous activity to posta bond equal to the highest reasonable estimate of the probableextent of its tort liability. Shareholders would be protected; acci-dent costs would be internalized; and the information costs of thecreditors of the affiliated corporations would be minimized.

The other and more important case in which piercing the corpo-rate veil may be warranted is where separate incorporation is mis-leading to creditors. In this case pooling the assets of the affiliatedcorporations for purposes of meeting creditors' claims would reducethe creditors' information and regulation costs. If corporations arepermitted to represent that they have greater assets to pay creditorsthan they actually have, the result will be to increase the costs thatcreditors must incur to ascertain the true creditworthiness of thecorporations with which they deal. Misrepresentation is a way ofincreasing a creditor's information costs, and the added costs are

5 For a summary of the cases, see H. HENN, HANDBOOK OF THE LAW OF CORPORATIONS AND

OTHER BUSINESS ENTERPRISES 252 n.25 (2d ed. 1970). I am assuming that the victim has nopre-existing contractual relationship with the taxi company-i.e., that he is a pedestrian, ora driver or occupant of another vehicle, rather than a passenger in the taxi. See note 16 supra.

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wasted from a social standpoint to the extent that the misrepresen-tation could be prevented at lower cost by an appropriate sanctionagainst it.31

Suppose for example that a bank holding company establishesa subsidiary to invest in real estate. The holding company gives thesubsidiary a name confusingly similar to that of the holding com-pany's banking subsidiary, and the real estate corporation leasesoffice space in the bank so that its offices appear to be bank offices.Unsophisticated creditors extend generous terms to the real estatesubsidiary on the reasonable belief that they are dealing with thebank itself." In these circumstances it would seem appropriate to"estop" (i.e., forbid) the bank holding company-or even the bankitself-to deny that it is the entity to which the creditors haveextended credit. To protect the legal separateness of affiliated cor-porations in this case would lead creditors as a class to invest asocially excessive amount of resources in determining the true cor-porate status of the entity to which they were asked to extendcredit.3

In general, a corporation's creditors should be allowed to reacha shareholder's assets when the shareholder, whether an individualor another corporation, has represented to the creditor that thoseassets are in fact available to satisfy any claim that the creditor mayassert against the debtor corporation. Misrepresentation is a famil-iar and widely used concept in the law, with strong intuitive appeal,and its use in the present context is firmly grounded in the econom-ics of credit and information. Moreover, it is the dominant approachin fact used by the courts in deciding whether to pierce the corporateveil. True, they often describe the criterion for piercing as whetherthe debtor corporation is merely an "agent," "alter ego," or "instru-mentality" of the shareholder, which as Landers points out is aconfusing test.39 A careful reading of these decisions suggests, how-ever, that in applying the "agent-alter ego-instrumentality" test thecourts commonly ask whether the parent engaged in conduct or

3, On the simple economics of fraud, see R. POSNER, REGULATION OF ADVERTISING BY THEFTC 3-9 (1973); for a more technical treatment, see Darby & Karni, Free Competition andthe Optimal Amount of Fraud, 16 J. LAW & ECON. 67 (1973); and on the underlying economicsof information, see G. STIGLER, THE ORGANIZATION OF INDUSTRY 171 (1968).

11 By an "unsophisticated" creditor, I mean one to whom the costs of ascertaining thetrue corporate status of the real estate company would be substantial. A "reasonable belief"means simply a belief based upon an optimal investigation of that corporate status.

"' See F. Black, M. Miller, & R. Posner, supra note t, at 28-31 (for a detailed discussionof this example).

", See Landers, supra note 1, at 626.

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made representations likely to deceive the creditor into thinkingthat the debtor had more assets than it really had or that the parentwas the real debtor.' And some courts have explicitly adopted amisrepresentation rationale for determining whether to pierce thecorporate veil.4 '

Because a misrepresentation test requires weighing the individ-ual facts and circumstances in each case and somehow discoveringwhat the creditor thought and whether he was reasonable in sothinking, it is more difficult to apply than a rule simply abolishingthe limited liability of shareholders that are corporations. But it isno more difficult to apply than Landers's interim test of "viability"(whatever that means) plus procedural observances, 4 and it couldbe made more precise in a number of ways.

One way would be to make clear that the test is an "objective"one; the issue should be not what the creditor in fact thought butwhat a reasonable person in the creditor's situation would havethought. Another way would be to differentiate among types of cred-itors in terms of their information costs. A financial creditor, suchas a consortium of banks, can discover the true financial situation

JO See, e.g., Weisser v. Mursam Shoe Corp., 127 F.2d 344, 345-47 (2d Cir. 1942); Stone

v. Eacho, 127 F.2d 284, 287-88 (4th Cir. 1942); Darling Stores Corp. v. Young Realty Co., 121F.2d 112, 113'(8th Cir. 1941); Arnold v. Phillips, 117 F.2d 497, 501 (5th Cir. 1941); Stark Elec.R.R. v. M'Ginty Contracting Co., 238 F. 657, 661-62 (6th Cir. 1917); Bartle v. Home OwnersCo-Operative, Inc., 309 N.Y. 103, 106, 127 N.E.2d 832, 833 (1955); North v. Higbee Co., 131Ohio St. 507, 514-18, 527, 3 N.E.2d 391, 394-95, 399 (1936); cf. Hospes v. Northwestern Mfg.& Car. Co., 48 Minn. 174, 198, 50 N.W. 1117, 1121 (1892). A particularly good example ofthe approach is Gledkill v. Fisher & Co., 272 Mich. 353, 388-89, 262 N.W. 371, 372-73 (1935),where the court states:

In the case at bar I am unable to find that any control exercised over the Westbrook-Lane Properties Corp. by Fisher & Co. [the parent] was exercised in such a manner asto defraud or wrong the plaintiffs, or that such domination was in any way injurious tothem. In entering into the land contract, plaintiffs relied entirely upon the Westbrook-Lane Corporation as the sole and actual purchaser. There was no representation byFisher & Co. that it was the real party in interest or that its responsibility was in backof the Westbrook-Lane Corporation. In fact, plaintiffs did not know at that time thattheir vendee was a subsidiary of the New Center Corporation or of Fisher & Co.1 See, e.g., Krivo Indus. Supply Co. v. National Distillers & Chem. Co., 483 F.2d 1098,

1102 (5th Cir. 1973); cf. Fisser v. International Bank, 282 F.2d 231, 238, 240 n.18 (2d Cir.1960). See also H. HENN, supra note 35, at 259; Note, Liability of a Corporation for Acts of aSubsidiary or Affiliate, 71 HARv. L. Rav. 1122, 1123, 1125 (1958).

12 See Landers, supra note 1, at 621-22, 625-26. Landers's test is actually more compli-cated than this since he would allow as a defense to the creditor's attempt to pierce the veila showing that the creditor knew or should have known what the assets of the corporationto which he extended credit really were. Id. at 625-26. Here and elsewhere Landers's articlesuggests that his interim test for veil piercing, at least, is based on a misrepresentationrational. See, e.g., id. at 623. But this interpretation is weakened by his emphatic rejectionof fraud as a basis for veil piercing. Id. at 626.

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of the debtor at lower cost than the trade creditor, and the latter inturn at lower cost than the nonbusiness creditor. (The financialcreditor generally extends the greatest amount of credit to eachdebtor and therefore has the greatest incentive to investigate thedebtor's creditworthiness; he also has the greatest degree of speciali-zation in appraising credit risk). Perhaps the courts should raise apresumption against piercing the veil in the case of the financialcreditor and a presumption in favor of piercing in the case of thenon-business creditor.

The courts might also develop rules for treating creditors on anaggregated basis, the usual approach in bankruptcy proceedings,rather than adjudicating the question of each creditor's relativeknowledge. An entire class of creditors might be granted a right torecover on the basis of evidence that a significant fraction of theirnumber was or was likely to have been misled. For example, werethere evidence that some trade creditors had actually or probablybeen misled, trade creditors as a class might be permitted to invokethe misrepresentation rationale as a basis for recovery against theaffiliate that had engaged in the misrepresentation. My conclusionis that a misrepresentation approach, which seems clearly sounderthan Landers's "single enterprise" approach as a matter of princi-ple, is susceptible of practical application.

The misrepresentation approach can also be used to answer theother two specific questions discussed by Landers-subordination ofthe parent's loans and consolidation of bankrupt affiliates. Al-though a rule of automatic subordination would be inappropriate,a creditor should be permitted to show that the parent's loan misledhim regarding the amount of assets the corporation had availablefor repayment of his loan. He may have reasonably believed that thecorporation had the usual equity capitalization for a corporation ofits size and line of business.43 If these reasonable expectations weredefeated because the parent supplied capital to the corporation inthe form of a loan rather than equity, the parent should be estoppedto deny that the loan is actually a part of the subsidiary's equitycapital. Similarly, consolidation of bankrupt affiliates should bepermitted where the creditor of one of the affiliates reasonably relied

,3 "Usual" capitalization could be determined by an examination of the capital struc-tures of a representative sample of the debtor's competitors, excluding any firm that was anaffiliate of another firm. The examination might, however, disclose a variance in the amountof capital among these firms large enough to negative the creditor's claim that he had reliedon the debtor's having the amount of capital that was "normal" for firms in its line ofbusiness; that is, there might be no norm.

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on an appearance of greater capitalization than in fact existed.In all cases in which estoppel is successfully invoked some com-

peting group of creditors will be disadvantaged whose expectationsmay have been just as reasonable as those of the creditors invokingestoppel. But to the extent that enforcing the estoppel or misrepre-sentation principle will discourage borrowers from using the corpo-rate form to mislead creditors, creditors in general will benefit-aswill society since the costs of credit transactions will be lower, andhence interest rates will be lower for any given level of risk.

The suggested approach deals automatically with the problemespecially troubling to Landers of the entrepreneur who, in order toavoid creditor and other claims, divides a truly unitary business intoa number of separate corporations. Insofar as creditors are misledby the proliferation of affiliated corporations, the misrepresentationprinciple affords them a remedy. If they are not misled, the prolifer-ation of corporations is harmless and should be ignored.

C. A Summary Comparison of the Suggested Approaches

The basic difference between Landers and me over the questionof the limited liability of affiliated corporations is that he thinksthat the abuses of limited liability are so prevalent in this contextas to warrant a rule dispensing with the need to prove that an abuseoccurred. I reject this approach because the principle of limitedliability has considerable merits even in the affiliation context,when all relevant costs and benefits are considered. Moreover, Iconjecture that Landers has exaggerated the prevalence of abusesby limiting his data source to reported bankruptcy cases. Cases inwhich the debtor actually becomes bankrupt are not likely to consti-tute a representative sample of credit transactions generally." Thisis especially so because under current law proof of misrepresentationis usually necessary for the corporate veil to be pierced. This meansthat someone who just reads cases on veil piercing will come awaywith an impression that the usual purpose and effect of corporateaffiliation is to mislead creditors. But any rule allowing the piercingof the corporate veil will affect business behavior across the entirerange of credit transactions rather than just the limited and unre-presentative sample of behavior of the defendants in reported veil-piercing cases.

It is also possible to exaggerate the virtues of simple legal rules,

" Cf. D. STANLEY & M. GIRTH, BANKRUPTCY: PROBLEMS, PROCESS, REFORM 107-17 (1971).

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such as a rule abolishing the limited liability of shareholders thatare corporations. There are two points to be made here. The first isthat the simple, flat rule opens up loopholes. Landers limits hisanalysis to the 100 percent affiliate. He does not discuss the casewhere some of the shares of the affiliate are owned by others. Thatcase is apparently to be taken care of by some other rule; or perhapslimited liability is to remain sacrosanct whenever there is less than100 percent ownership by the parent or affiliate. But to draw sosharp a legal distinction between the case where the parent owns 100percent of the common stock of its subsidiary and the case where itowns 99.9 percent is not only arbitrary; it invites the creation of tinyminority stock interests for the precise purpose of escaping Lan-ders's rules. In a complete analysis, Landers would be forced topropose additional rules to close up this loophole.45 A misrepresen-tation approach does not have this defect because it is unaffectedby the presence of minority shareholders save insofar as their pres-ence might, in a rare case, affect creditors' reasonable expectations.

The second point is that a rule abolishing the limited liabilityof separate corporations, while simpler than one that makes veilpiercing contingent on proof of misrepresentation, is not necessarilycheaper to administer than the latter rule. The question whethersimple rules really reduce the net costs of legal administration hasbeen extensively discussed in the context of whether to supplantnegligence by strict liability in tort cases. Proponents of strict liabil-ity point out, correctly, that it simplifies the trial of the individualcase by eliminating one of the issues in the trial-the issue offault-and that by simplifying the trial, and thereby facilitatingprediction of its outcome, it also reduces the fraction of disputeslikely to be litigated. However, the proponents typically ignore thefact that strict liability would expand the universe of potentialclaims by increasing the scope of liability for injury-creating con-duct. Each case might be cheaper to try, and the fraction of claimsactually tried might be smaller, but the absolute number of claimstried would be larger, and the total administrative costs-which arethe product of the cost per case litigated, the fraction of claimslitigated, and the total number of claims-might actually rise."

It is the same with piercing the corporate veil. If the veil may

A similar problem is created by his proposal for subordinating parents' loans. Parentswould have an incentive to contribute capital in forms (e.g., equipment leases) that mightescape being classified as "loans" for purposes of the rule.

49 See Posner, Strict Liability: A Comment, 2 J. LEGAL STUDIES 205, 209 (1973).

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always be pierced to reach an affiliated corporation's assets, thenthe litigation of each veil-piercing case will be simpler, and thefraction of creditors' claims against affiliated corporations that arelitigated will therefore be smaller; but the number of potentialclaims by creditors against parent or other affiliated corporationswill be much greater than under a rule that entitles the creditor topierce the corporate veil only if he has been misled. Thus, if theincidence of abuse of the corporate form in the affiliation setting isin fact small-if most creditors of affiliated corporations are notmisled into thinking that they are dealing with the debtor's parentor affiliated corporation-the expansion of liability implicit in Lan-ders's suggested approach could result in greatly increased adminis-trative costs by allowing a large number of claims to be pressed thatwould be frivolous under existing law.

The most serious objection to Landers's suggested approach,however, is that it would impair a socially valuable principle, thatof limited corporate liability, which I have argued retains much ofits importance in the context of affiliated corporations. The risks ofsmall business might be materially enhanced if small venturerscould not limit their risk in undertaking a new venture to theirinvestment in that venture. Although Landers appears to be willingto allow affiliated corporations expressly to negotiate for limitedliability, this would not take care of the investor's exposure to tortliability; and disclaiming liability to the many small trade and non-business creditors with which a corporation deals could be quitecostly-even prohibitively so if the courts refused to honor simpledisclaimers of unlimited liability.

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the rights of creditors of affiliated...

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